Beijing’s taper challenge

Commentary: Are Fed’s policy plans a trigger for Chinese deflation?

HONG KONG (MarketWatch) — China’s leaders will be busy preparing for this weekend’s Communist Party plenum meeting with one eye on Washington. The resurfacing of taper talk at the Federal Reserve adds more minefields to the difficult policy choices already facing Beijing as its juggles liberalizing its financial markets and deleveraging the economy.

Now it must also second-guess the impact of the Fed potentially removing the liquidity punch bowl. Some analysts see an uncomfortable end to the debt party — namely, deflation.

China will have trouble distancing itself from the actions of the Fed so long as it keep a crawling peg to the greenback and largely imports U.S. monetary policy. If we are really near the end of five years of quantitative easing, it should come as little surprise that China’ debt-swollen economy will feel a distinct chill.

Reuters

Yet the recent consensus appears to be that China has less to fear from tapering. In Asia, it was countries such as India and Indonesia that bore the brunt of the taper fallout this summer, with their currencies sinking as foreign funds exited.

As investors went into “risk off” mode, it was the riskier emerging-market countries with current-account deficits and suspect fundamentals that were punished. China, with its current-account surplus and commitment to growth looked comparatively robust.

Another argument says that China’s sealed financial system, with a closed capital account and largely pegged currency, afforded it further protection. This worked before, when China’s financial isolation allowed it to escape direct contagion from the financial crisis following the Lehman Brothers.

And if you look at the currency markets, while many Asian currencies have been buffeted by the on-off taper debate, the policy-driven yuan
USDCNY, -0.15%
has strengthened this year. In fact, since September when it first appeared that the Fed’s tapering would be postponed, China has reportedly even been attracting money rerouted from India and Indonesia, as the pegged and rising yuan began looking like a “safe haven.”

But there are several holes in this narrative. The tell-tale signs of financial stress are likely to show up elsewhere under a system of policy-led exchange rates.

Brokerage Société Générale argues that there are other traps laid by quantitative easing that China has to watch out for.

They say that while QE in the West generated significant capital inflows to emerging economies, in China this was more pronounced , since it combined with domestic government policies to boost fixed-asset investment. At first, they argue, this was welcome as it boosted demand for commodities and other capital-expenditure-related goods.

But increasingly, this boom in fixed-asset investment driven by easy money has been less benign. Now it’s creating a range of ills from worsening excess capacity to poor capital returns and a shaky banking system.

The end result of this excess capacity and other unproductive investment is a deflationary hangover that could ripple round the world, says SocGen.

In most economies, unproductive investment is by its nature deflationary, as it destroys capital. The general absence of reports of heavy bad-debt loads in China suggests it has yet to have that day of reckoning, although the performance of domestic stocks might suggest otherwise.

For analysts on the lookout for signs of deflation in China, one of the first places to look is invariably the property market.

Here, the interplay of quantitative easing and China’s fixed exchange rate again looks significant, as it can mean asset markets take the strain of adjusting to an overly loose monetary policy.

In China, the asset market to watch has long been property. Next to the domestic stock market it looks comparatively transparent, while the limited investment options available to savers beyond domestic bank accounts tends to funnel funds into real estate.

Once again, China is on a renewed property-bubble alert as prices reached record highs in October. This week the Shenzhen government reacted, raising the minimum down payment on a second home from 60% to 70%.

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The dilemma for Beijing is how to manage this market when key policy is effectively being set in Washington. The risk is that both China’s policy makers and the Fed might adopt more restrictive policies at the same time, finally popping the property bubble and leading to a deflationary correction.

Ultimately, the solution should be for China to run its own monetary policy independent of the U.S. This is a key reason many believe Beijing is so determined to proceed with difficult financial reform such as interest-rate liberalization and an opening of the capital account.

Yet in the meantime, China’s leadership face a difficult balancing act. To generate international demand for the yuan, policy makers are under pressure to keep the currency strong, which may just suck in more inflows that worsen speculative bubbles and unproductive investment.

One way or another, Beijing will face a reckoning from its fixed-asset-investment binge. But don’t be surprised if the timing is dictated by the Fed rather than the People’s Bank of China.

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